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On golden bond

Tax planning is – or should be – enjoying a time of higher than usual interest and, hopefully, demand. The reason why has been well explained in this column in past weeks but here it is again for good measure. In a time when investment markets are difficult, interest levels in increasing the bottom line through tax planning should increase.

Only just recently it was reported that, for higher-rate taxpayers, it was the tax relief on pension contributions that prevented them making a loss over the last 10 years. This finding was based on a survey by investment data provider Lipper.

My comments over the past few weeks have been about improving returns for investors through smart tax planning and especially smart (albeit far from groundbreaking) wrapper choice. Of course, unlike these recent findings in respect of pensions, you need a positive return in the first place for the tax qualities of a particular product wrapper to kick in to improve the bottom line. So I will assume for the remainder of this article that we get one.

As I mentioned last week (and this is something that has been given greater prominence recently, especially through the Barclays capital report), the yield on equities is an extremely important factor in driving returns on investments. Currently, the FTSE yield is at around 3.9 per cent. This is generally accepted to be highly attractive, especially given the chance of capital growth on equities as well.

All other things (such as charges) being equal, it must make sense for the investments producing the dividends to be held inside the most tax-attractive environment, that is, one that minimises or avoids tax on reinvested income. I made it clear last week that I believe a UK life fund represents such an environment.

So, too (at least in most cases), would a non-UK life fund, for example, one in a tax haven, but it is important to bear in mind that, under such an investment, the investor will not be entitled to any tax credit when an offshore bond is encashed, whereas the investor in a UK bond will secure a full basic-rate tax credit.

Thus, the extent to which growth in the unit value of the bond has been driven by reinvested dividends will quite radically alter the outcome from these two products.

So, keeping our attention (for the moment) on the UK bond, it is worth considering that if we just concentrate on reinvested dividends at the current rate of 3.9 per cent and assume that there is no capital growth, the value of a £100,000 investment at the end of 10 years – taking no account of charges – would be £146,607. The gain would be £46,607 and, on encashment, the higher-rate taxpayer would pay tax at 18 per cent, leaving a net gain of £38,218.

If these dividends had been reinvested outside the protected environment of the UK bond, it would have been necessary to take account of tax at 32.5 per cent on the grossed-up dividend. The liability ascertained would then be reduced by the tax credit of 10 per cent.

Now, this liability would probably be paid out of other income on January 31 in the tax year following that in which the dividend was received. But, in any comparison of dividends reinvested inside or outside a bond, it is fair, I think, to take account of the tax and to deduct it from the reinvested dividend before reinvestment, so to speak, in order to compare the returns. That said, the return (after tax) on the non-bonded investments and reinvested income would be £33,416 on the £100,000 investment – again, taking no account of charges.

Of course, as income tax will have been borne along the way and each reinvested dividend will have constituted a fresh investment for capital gains tax (whether or not it were separately identified would depend on the nature of the outer wrapper), there will be no further tax payable at the end of 10 years.

Nevertheless, the net amount received from the non-bonded investment with net dividends reinvested would be £133,416. The amount from the bond would be £138,218. Both amounts ignore charges.

The improvement, just by virtue of tax wrapper choice, is 14 per cent – a reasonable increase in return these days. Of course, if there is also to be capital growth, then, depending on the investor&#39s tax profile, available exemptions and so on, the bond may not be the optimum wrapper. That is where the value of advice comes in.


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